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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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FA2010: risk transfer schemes: example

Company A is a member of X Group. It invests £100m in yen-denominated shares.

X group wishes to protect itself from the foreign exchange risk from yen depreciating against sterling.

If A borrowed £100m equivalent yen to hedge the shares, the foreign exchange movement on the borrowing would not be taxed until the shares were disposed of due to the tax matching provisions.

However, if yen interest rates are lower than sterling, X has the opportunity to benefit from that lower borrowing rate while not being exposed to the risk of the yen appreciating against sterling (which would increase the sterling equivalent amount to be repaid) by passing the foreign exchange risk on to the Exchequer.

So, Company B, another member of Group X undertakes the borrowing.

Instead of borrowing the £100m sterling equivalent of yen needed to hedge the shareholding it actually borrows £139m equivalent. The quantum of the borrowing in excess of that required to hedge the shareholding (hence the term ‘overhedge’) is determined by grossing-up the £100m by the corporation tax rate (assume CT rate is 28%. £100m net of CT would be £72m. Therefore the gross-up is £100m x 100/72 = £139m).

So, what happens?

Scenario 1 - Sterling depreciates by 10% against yen

Shareholding

The shareholding is now worth £110m = £10m gain (but no immediate tax effect).

Borrowing

The borrowing is now equivalent to £152.9m = £13.9m loss

This £13.9m loss obtains tax relief at 28% = £3.9m

So, overall, the borrowing has made a £10m loss (post-tax).

Overall

The £10m gain on the shares is negated by the £10m loss on the borrowing.

Overall - the group is flat on a post-tax basis.

Scenario 2 - Sterling appreciates by 10% against yen

Shareholding

The shareholding is now worth £90m = £10m loss (but no immediate tax effect).

Borrowing

The borrowing is now equivalent to £125.1m = £13.9m gain

This £13.9m gain is taxed at 28% = £3.9m

So, overall, the borrowing has made a £10m gain (post-tax).

Overall

The £10m loss on the shares is negated by the £10m gain on the borrowing.

Overall - the group is flat on a post-tax basis.